Microfoundations Models: Square Peg, Round Hole

I think part of the problem with microfoundations modeling (at least how many of them are done) is trying to force a very square peg into a very round hole.

Here's Simon Wren-Lewis:

It is hard [microfoundations modeling] because these models need to be internally consistent. If we think that, say, consumption in the real world shows more inertia than in the baseline intertemporal model, we cannot just add some lags into the aggregate consumption function. Instead we need to think about what microeconomic phenomena might generate that inertia. We need to rework all relevant optimisation problems adding in this new ingredient. Many other aggregate relationships besides the consumption function could change as a result. When we do this, we might find that although our new idea does the trick for consumption, it leads to implausible behaviour elsewhere, and so we need to go back to the drawing board. This internal consistency criteria is partly what gives these models their strength.

It is hard then, in part, because you are trying to fit a square peg into a round hole. You're trying to fit perfect optimizing behavior of individuals ("internal consistency") to the behavior of aggregates that did NOT, in fact, result from perfect optimizing behavior of individuals. They resulted from very imperfect optimization of very imperfect individuals, with very limited expertise, information, time for analysis, and self-discipline, to name a few (and I can tell you first hand, as a businessman and family man, that with how busy and distracted people are, it can take them a while to analyze and react, even with their imperfect public knowledge, analysis, and reaction).

Here's Simon again:

It took many years for macroeconomists to develop theories of price rigidity in which all agents maximised and expectations were rational…

Again, square peg, round hole. It's very hard to find a model where every single person has perfect maximization and perfect rational expectations, and you still get, at least qualitatively, the type of aggregate behavior we see in the real world, because that aggregate behavior we see in the real world is not generated from individuals who all have perfect maximization and perfect rational expectations, not even close for many things.

If, on the other hand, you're just modeling the behavior of the aggregate based on how we have actually seen it behave, not some ideal, this gives you an advantage in creating a more realistic model that can better predict, and be used to study the effects of policy. It's not without problems though, even though it has important advantages:

-- There's the Lucas critique, although sometimes this effect may be very weak and/or slow.

-- We sometimes don't have a great deal of relevant historical data to model the aggregates on.

-- There can be substantial regime change, so that past history of the aggregate(s) is not very representative, or relevant, to the present (Of course, you should look for enduring features of the aggregate(s) that survive regime shifts.)

So, like in the physical sciences (Noah gives the example of meteorology), it's best to study and model both the micro units and the aggregates as a whole.

And, it would be nice if our microfoundations models could make more realistic assumptions about the knowledge, expertise, education, self-discipline, and other behavioral factors of the micro units, i.e. people. I know this can make it very hard, or intractable, to solve the model in closed form, but why not just have it be a computer simulation, to test things with a very complicated, and mathematically and global-optimizationally intractable, but much more realistic model? That could be extremely useful.

Short of more realistic microfoundations models, let's please keep in mind, a model is only as good as its interpretation, and the smartest interpretation is usually far from literal.

Haugen's Critique of Microfoundations in Finance

In the recent round of criticisms of microfoundations modeling (see, for example, here, here, and here), there's an important criticsim that I haven't seen really hit directly: If you're going to start out micro and aggregate up to a very complicated reality, then it's very hard (at least) to do without making extremely strong, simplifying, and unrealistic assumptions, and that's where the microfondations models can be very unrealistic, and bad for understanding, predicting, and policy.

This issue is in finance too. One of the biggest, and certainly loudest, critics of microfounded finance models is Robert Haugen. Haugen now runs an investment services firm, but he was previously a finance professor at University of California, Irvine, and is #17 on a publications' prestige weighted list of finance's most prolific authors, 1959 -- 2008.

Haugen's criticism is that the aggregate of very complicated, highly interacted, micro behavior can be better understood if you just observe the behavior of that aggregate, rather than trying to understand it, predict it, and make good policy from modeling micro unit behavior and then aggregating up.

In finance, then, you can understand and model the behavior of financial asset markets just by looking at how those markets behave over time, and creating a model to fit that observed behavior. This will get you a much more accurate, realistic, and useful model, than if you make very simplifying assumptions about individual behavior and interaction so that it's tractable to aggregate up to the market as a whole.

So in other words, a model of aggregates can be much more realistic and accurate in describing the behavior of those aggregates because you aren't forced to make extremely unrealistic simplifying assumptions about micro units in order to make aggregating them tractable.

In Haugen's own words:

Chaos aficionados sometimes use the example of smoke from a cigarette rising from an ashtray. The smoke rises in an orderly and predictable fashion in the first few inches. Then the individual particles, each unique, begin to interact. The interactions become important. Order turns to complexity. Complexity turns to chaotic turbulence... ("The New Finance", 2004, 3rd Edition, page 122)

How then to understand and predict the behavior of an interactive system of traders and their agents?

Not by taking a micro approach, where you focus on the behaviors of individual agents, assume uniformity in their behaviors, and mathematically calculate the collective outcome of these behaviors.

Aggregation will take you nowhere.

Instead take a macro approach. Observe the outcomes of the interaction – market-pricing behaviors. Search for tendencies after the dynamics of the interactions play themselves out.

View, understand, and then predict the behavior of the macro environment, rather than attempting to go from assumptions about micro to predictions about macro... (page 123)

For more on this see here.

Now you may reply, Lucas critique! But, as is a theme of this post, let's be realistic. The Lucas critique in many cases relies on people having a ridiculous amount of knowledge, expertise, free time (or little value for the time they must spend analyzing economic, political, and governmental policy, something that few people get much enjoyment from), and self-discipline to have much effect. Sometimes the Lucas effect may be very weak (or slow).

Take a look at surveys of people's knowledge of the governments' budgets and then tell me that it's common for people to accurately, precisely, and regularly adjust their consumption to expected changes in government spending.

In the words of Paul Krugman:

Does this argument sound convincing? It did (and still does) to many economists. Akerloff pointed out, however, that it depends critically on the assumption that people do something that they are unlikely to do in real life: take account of the implications of current government spending for their future tax liabilities. That is, the claim that deficits don't matter implicitly assumes that ordinary families sit around the dinner table and say, "I read in the paper that President Clinton plans to spend $150 billion on infrastructure over the next five years; he's going to have to raise taxes to pay for that, even though he says he won't, so we're going to have to reduce our monthly budget by $12.36."

...the truth is that even families of brilliant economists don't have conversations like this. No, the point is that the effort isn't worth it. If a family has arrived at a sensible rule of thumb for deciding how much to spend, trying to improve on that rule by making sophisticated predictions about the future implications of government spending will improve the families decisions so little that it isn't worth the investment of time and attention.

– "Peddling Prosperity", 1994, page 208.

To: John Cochrane, Re: Positional Externalites

John,

Years ago, when your excellent book, Asset Pricing, first came out, I was a finance PhD student. I found some errors and sent you an email with them, and some feedback and suggestions I had. You replied, and were very gracious. So I'm hoping you might reply to this.

In your current blog post, you write:

Frank's article is hilarious in another way. Higher taxes are fine, he says, because more money won't make you feel better when everyone around you is wealthier too. Too much low-hanging fruit there, just go read it and have a laugh. Or shake your head in amazement. No, he's not joking.

With regard to Frank's contention that position/rank/prestige/context is a substantial part of how much utility the average person gets from goods, please give us the evidence why this is wrong. Please don't just say, ha ha, it's hilarious, it's too obvious. Because Frank's contention was published in one of economics' top journals, the American Economic Review, "Positional Externalities Cause Large and Preventable Welfare Losses." (2005).

And other authors have based top journal papers on the same contention. For example:

"Neighbors as Negatives: Relative Earnings and Well Being", by Erzo Luttmer, Quarterly Journal of Economics, August 2005.

"Diamonds Are a Government's Best Friend: Burden-Free Taxes on Goods Valued for Their Values", by Yew-Kwang Ng, American Economic Review, March 1987

Now, surely the wrongness of this idea can't be so laughably obvious if the editors of some of economics' top journals repeatedly published articles based on it. And, not to beat a dead horse, Nobel Prize winning economist Gary Becker wrote a paper based on this idea:

"Evolutionary Efficiency and Happiness", Journal of Political Economy, April, 2007 (with Louis Rayo)

Quoting Becker and Rayo:

For a long time, utility was assumed to depend only on the absolute level of an individual’s economic conditions. However, a large body of research now shows that the relative level of these conditions also plays a central role: an individual’s utility, whether defined in terms of decision making or hedonic experience, tends to be sharply influenced by his personal history and social environment. Examples include Markowitz (1952), Stigler and Becker (1977), Frank (1985), Constantinides (1990), Easterlin (1995), Clark and Oswald (1996), and Frederick and Loewenstein (1999).

-- pages 302-3.

So please John, don't treat Frank's general idea as laughably, obviously wrong. Becker's not an idiot. None of the very successful economists noted above are idiots. The editors of the AER, the QJE, and the JPE aren't idiots. So if positional/context/prestige externalites are insignificant factors in peoples' utility we're going to need your evidence for that.

For me personally, I'd be stunned if position/rank/context/prestige were insignificant or insubstantial factors in how much utility people get from clothes, cars, homes, etc., if the utility a person gets from a given house or car is not substantially different if it's in the 90th percentile or the 10th. I would be at a complete loss to explain all that I've seen, read, and experienced, day by day, in 48 years in this world. It would be hard for me to think of any alternative hypothesis that would fit it. But I'm very open to your evidence, and very curious to hear it.

Sincerely,

Richard Serlin

Who does more "bossing around"?

From Jonathan Chait today:

Consider Will’s column from the past weekend. It centered primarily on climate change, a favorite Will topic – he is a climate-science skeptic. Occasionally, Will ventures forth to cast doubt on the science directly, but he usually takes the total falseness of the climate-science field for granted and proceeds from that basis. In his recent column, Will argues that liberals made up the global warming scare in order to justify their desire to ration energy:

Because progressivism exists to justify a few people bossing around most people...

Now, aside from the conservative anti-science, I love this line, "Because progressivism exists to justify a few people bossing around most people..."

Even at the height of government power in the 1960s, when were people ever anywhere near as bossed around by government as by the free market, as by, say, THEIR BOSS!

The more income inequality we have, the more plutocracy we have, the more people get bossed around. It's very often government that PREVENTS large numbers of people from being bossed around. Try being an indentured servant to a private student loan holder, after being conned into a culinary institute and now working at Taco Bell. See how bossed around you are.

Yeah, before the progressive movement in the early 1900s, people were never bossed around.

Republicans: Cut all the meat if you find any waste!

A typical Republican response to evidence of the value of government is, yeah, and what about this one time there was waste! I mean you could talk about the polio vaccine, and they'd say, yeah, and this one guy in Salk's laboratory stole office supplies and used to sleep in the back room. You could talk about how the passage of Social Security (which they fought tooth and nail; it was the death of freedom circa 1935) turned senior citizens from by far the biggest group in poverty to the smallest, and they'll say, yeah, what about this guy who got it fraudulently at age 58.

This should be obvious, but if you're ending anything because you can find some waste in it, you might as well kill yourself right now, because there will be nothing left and you'll starve. In every large endeavor you'll find some waste. You could take the most successful private company in the world, Apple, Sony, you name it, and you find tons of examples of waste; employees watching porn on their computers, sexual harassment, lavish corporate jets,...

The particular example that set this off is a post by Brad Plumer at Ezra Klein's Wonkblog. It shows how slashing of government employees in some areas cost far more than it saved. In the comments we see responses like, yeah, "Using the SEC and the minerals office as examples - where porn was viewed thousands of times as the economy crashed?"

As liberals, and just intelligent people, we have to make an effort to call out these ridiculous -- but pulling at the emotions -- arguments from Republicans whenever we hear them. You don't throw away all of the valuable, or essential, meat just because there exists some fat. I don't decide not to send my daughter to college because there was the Penn State scandal. I don't throw my Vanguard portfolio in the trash as worthless because my cousin knows this one guy who works there who played computer games on the job.

Massive Income Inequality, and Achievement among the 99%

The latest from Tyler Cowen:

Nonetheless, higher income inequality will increase the appeal of traditional mores — of discipline and hard work — because they bolster one’s chances of advancing economically.

Let's be clear here:

Severe income inequality DECREASES, not increases, the chances of the poor and middle class to get ahead, not that Libretario Cowen would care much; as an extreme libertarian he'd rather have massive suffering, loss, and decreased growth rather than give up even a tiny amount of personal freedom.

It DECREASES the chance to get ahead when you have to work 40 hours per week while going to college full time, thus having far less time to study, learn, and succeed. Studies have shown that this substantially reduces the odds of graduating, as well as learning, and GPA. But, hey, let's cut college aid even further, so we have even more income inequality!

It DECREASES the chance to get ahead when poor –  and middle class – children have no health insurance, so they grow up sicker, and more poorly developed mentally and physically, and when their mothers can't afford to spend the time to breastfeed due to work, or to buy and cook the healthier foods, whole fruits and vegetables. Or when they have to live in more and more polluted areas because of Republican deregulation. But, hey, no problem, the rich can afford to move away from the pollution. It's only the children of the poor – and middle class – who as a result will be sicker, dumber, and more likely to suffer from behavioral problems.

It DECREASES the chance to get ahead when poor and middle class children can't go to pre-school because their parents can't afford it, or they can only afford day care which just sits them in front of the TV because that's a lot less time consuming and expensive than teaching.

It DECREASES the chance to get ahead when little regulated for-profit schools can prey on unknowing young people with promises of great careers from substandard education that does little to increase earnings, but costs 10 times as much as GOVERNMENT community colleges, and is financed with loan shark private student loans that can quickly grow exponentially so they're impossible to ever pay off, but thanks to the Republicans can never be escaped in bankruptcy – Welcome back indentured servitude! Always nice to ruin lives before they can even get started, and the poor kid has any idea even what's going on. But hey, Pure Free Market! And better to ruin a billion lives than give up even one micron of personal freedom, right Libretario?

But does this "increase the appeal of traditional mores — of discipline and hard work", as Libretario says? Taken to this kind of extreme, especially for the poor, it can do the opposite, because it can increase hopelessness, people just giving up and turning to crime and an underclass mentality, people just thinking why try.

Remember, it may not be nice and simple, but the reality is that lots of things graph U-shaped, or upside-down U, not simple straight line, always increasing or always decreasing. A certain amount of income inequality increases discipline and hard work, but at some point it gets so extreme that things just look too daunting or herculean for most,  hopeless and rigged, and then effort, and a belief in the payoff of hard work, starts decreasing.

You increase discipline and hard work, and achievement, overall, by giving people the means to succeed and clear, reasonably realistic looking, routes to success. Make college more affordable (a lot more), give all children healthcare and truly nutritious school breakfasts and lunches, and quality pre-school and daycare, give middle aged mothers and fathers who have made mistakes, or just had no idea of how important education was when they were kids, but want to work hard now and turn it around, the realistic possibility of going back to school and getting a college degree, without making it a herculean task that few will attempt, let alone succeed at.

Do these kinds of things, and then you'll see both more effort AND more success, because effort is a lot more productive if you provide tools and resources to go with it, and you get a lot more effort from most people if you make the goal look realistically achievable, not a daunting, or herculean, task. Yes, some people will take on daunting or herculean tasks; they won't shy away, and they will work themselves to the bone, and may succeed. But do you want only this minority of people to get ahead and do well, and screw the majority, or do you want to make the high return investment to make the majority highly productive and financially comfortable too?

Of course, Libretario, you don't actually care, if it means giving up even a speck of personal freedom.

Sharply Progressive Taxation Virtuous Circle

One important benefit of sharply progressive taxation that I haven't really heard much is that it makes the rich a lot less capable of controlling, corrupting, and perverting government with massive legal bribes, I mean donations. Importantly, as well, the middle class has a lot more money to donate to compete with the rich.

With a sharp increase in the progressivity of taxes (all taxes, including state and local), the rich become less capable of controlling and corrupting government, making it a lot less efficient. Thus, the increase in progressivity makes government more efficient, increasing confidence in government along with its performance, creating a virtuous circle of government confidence and performance. At the same time, the rich have a lot less money to fund the right wing propaganda machine, thus it becomes a lot less able to grossly distort people's image of government's efficiency, usefulness, and importance, so again more confidence in government. And this leads to greater public investment and insurance, which greatly increases long run growth and total societal utility, with the gains widespread, instead of only at the top.

It looks like such a virtuous circle may have occurred in the early part of the 20th century. The top marginal income tax rate went from 7% in 1915 to 77% just three years later!  This was shortly followed by the New Deal, unprecedented levels of professionalism and efficiency in civil service, and respect for it, a golden era of high and evenly spread growth, the birth of the great middle class, widespread and easy college access, the highest level of college graduates in the world (after a generation of Republican dominance we're down to 11th), Medicare, and Medicaid.

Sadly, with the generation of Republican dominance, the circle has been reversed, from virtuous to vicious. The top marginal income tax rate dropped from 70% in 1980 to 28% in 1988. The rich, with their great increase in wealth, gained ever more control of government, deregulated finance, and much else, lavishly funded a vast propaganda machine to slander government, slashed college aid and education (relative to inflation, population and/or it's fast growing importance in a high-tech world), slashed public investment and social insurance (as always relative to inflation, population growth, and/or growing importance/need), and we've had a generation of tragic decline, with the rest of the world catching up to us or passing us in many key areas. And income inequality has gone through the roof, with incomes for most stagnating or declining for a generation, and a third of the population 18-64 without health insurance at least some time over the last two years. In addition, the right uses it's money-fueled influence and electoral victories to degrade government whenever possible, then they say, see, government can't do anything well, which helps them to degrade it further, and the viscous circle continues.

Cornell economist Robert Frank gives one huge benefit of sharply progressive taxation that's little if ever heard, allaying monumental positional/context/prestige externalities; another big one is preventing the rich from controlling and degrading government.